All investors make mistakes. The trick is to avoid making the same one twice. Behavioural economist James Montier has flagged up some of the most common ways in which investors sabotage themselves in his latest book, The Little Book of Behavioral Investing. Here are five of his tips.
1. Be patient
Modern investors just can't seem to sit still. As Montier notes, the average stock holding period in the 1950s and 1960s was around seven to eight years. Now, based on NYSE data, it's just six months. That impatience is costing us. A study by Terrance Odean and Brad Barber looked at activity levels for 66,000 stock trading accounts between 1991 and 1996. During that period the market averaged a return of 18% a year. Yet the most frequent traders managed just 12% a year.
So, develop patience and discipline. If you don't get a decent opportunity to invest for six months, do what Warren Buffett does: nothing. As economist Paul Samuelson once observed, long-term "should be boring". If it's adrenaline-pumping fun you want, try spread-betting or the horses.
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2. Block out noise
One reason we're prone to over-trading is because we are constantly bombarded by news and stock tips what Montier calls "distracting noise". Ignore it. Life is too short to be spent gazing fretfully at your computer screen. If you choose your investments with the long term in mind, then your case for holding them isn't going to change with every new economic data release, or drop in the stockmarket.
How do you do this? Stick to three basic principles. First, use fundamental analysis (such as price/earnings ratios and dividend yields) to determine whether a stock is undervalued. Next, check (using the Altman Z score, for example) whether the firm is in danger of going bust. Thirdly, check what the management is doing with the firm's cash. Are they adding value, or squandering it?
There are various methods of doing these things we regularly write about them here but the point is that you are looking to buy stocks when they are cheap. Eventually, the market will cotton on and the price will rise. As long as your initial rationale for buying is solid, you'll be able to avoid being panicked into selling in the meantime by the odd down day on the wider market, for example.
3. Try to prove yourself wrong
Another thing to be aware of when investing is over-confidence. The truth is that we don't like to think we're wrong. So we look for data that fits our views. In fact, we are twice as likely to look for information that supports our investment choices than we are to look at awkward data, says Montier.
That's all very well, but being convinced that you're right won't prevent a poorly chosen stock from tanking and taking your capital with it. So how do you get around this tendency? When you first invest, make a note of why you bought in. Then do a regular strengths, weaknesses, opportunities and threats analysis on each of your major holdings. Really focus on the weaknesses: try to "kill the company", says Montier, by asking what could go wrong. Would you buy again now, or are you hanging on to a dud simply because you refuse to accept bad news?
4. Don't overcommit to one share
Buying the occasional dud is nothing to be ashamed of. Regardless of how sound your investment process is, not every share you pick will be a winner. But this is when another of our psychological tics starts to make life difficult. The trouble is, we hate losing more than we enjoy winning. In fact, we hate realising losses up to 2.5 times more than we enjoy gains, notes Montier. So it's all too easy to try to "ride out" a paper loss, or, worse still, "buy on the dips", in the hope things will eventually come good. But what you forget is that money sitting in a duff investment could be generating a decent return if invested elsewhere. One solution is to set an investment limit. For example, you might decide that no single stock can account for more than 5% of your portfolio. That way you can't build a position that you then find too painful to let go of.
5. Avoid bubbles
Why are investment bubbles so common? The reason, says Montier, is over-optimism. Just as we all think we're above-average drivers, we never see ourselves as investing's "greater fools". We'll always get out before the bubble bursts. But as the widespread pain caused by bursting bubbles shows, plenty of people don't. The answer is simple: if your valuation measures say it looks like a bubble, then avoid it. None of us is a "slave to the benchmark", worrying, as a fund manager does, about career risk from sitting out a bubble. There is no published bottom quartile for a retail investor. So, if in doubt, stay out.
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